There are many benefits that come with tax-advantaged retirement accounts such as an individual retirement account (IRA) or a 401(k). These accounts provide tax-deferred growth (or tax-free, in the case of the Roth IRA), large contribution limits and, in the case of the 401(k), the potential for an additional investment into your account from your employer just for contributing.
When you leave an employer, you need to figure out what to do with your 401(k) account. Some companies allow you to keep your account with the 401(k) plan, but many require you to roll over your 401(k) balance into an IRA.
The Benefits of Rolling Over Your 401(k) Into an IRA
In most cases, keeping retirement savings in a tax-advantaged account is the best course of action. If you withdraw your balance from a 401(k) instead of rolling it over, you could be subject to a 10% early withdrawal penalty, which could potentially lead to losing thousands of dollars to the Internal Revenue Service (IRS).
Rolling the balance directly into an IRA preserves the money's tax-advantaged status and helps you avoid any unnecessary fees. In many cases, it can lead to better choices. In many cases, 401(k)s offer limited menus of investment choices, or they can be littered with high-cost options and poor performers. With an IRA, almost any stock, bond, mutual fund or exchange-traded fund (ETF) is in play. This flexibility gives you the freedom to create a diversified low-cost portfolio that gives you a better chance of achieving your retirement goals.
Taking Your Time
In times of market volatility, the decision of what to do with your 401(k) can be more challenging. You need to decide where to roll over your account balances, and you need to decide what to invest in. It can make for a confusing time, and confusion often leads to poor investment choices.
There's no real rush to make a rapid investment decision. While you may have a 60- to 90-day window to roll your 401(k) out of the company, this short time frame doesn't necessarily commit you to making an investment choice. Investors are often counseled to simply roll their account balances into savings or money market accounts if they need additional time to figure out what to do.
This rollover moves the money into an essentially risk-free account that satisfies the company's rules for moving money out of the plan, and it meets IRS guidelines for keeping tax-advantaged savings in a tax-advantaged account. You can keep the balance in this cash account until you make a decision about a longer-term allocation for the money.
Perhaps one of the greatest advantages of rolling over your 401(k) in a volatile market while sitting on cash is that it gives you an idea about your true risk tolerance. You may be willing to be risky when the market is going up, and you're likely to be risk-averse when things are down. If the market's volatility makes you a little queasy, consider a more conservative long-term asset allocation.
The Benefits of Dollar Cost Averaging
Investors often fear moving a large amount of money into the market all at once because of the fear of getting in at the wrong time. As an extreme example, if you had rolled your 401(k) into the market at the top of the tech bubble 15 years ago, you would be looking at losses of over 70% from peak to trough less than three years later. Those types of cases of bad luck are rare, but they do illustrate the point that the entry point of an investment can be one of the biggest risks facing the overall return on a particular investment.
Financial advisors often suggest that dollar cost averaging may be the best way to move a larger amount of money into the market. Dollar cost averaging involves moving just a percentage of your money into a particular investment at a time. This helps to invest the money at several different points and several different prices, which limits the risk of going all in at the wrong time. Dollar cost averaging also helps lower the cost basis of the investment.
As is the case with many important and potentially costly decisions, it's often best to slow down, think things through and then make an appropriate decision. Impulsive decision-making can often lead to regrets – and in the investing world, that can be costly.
While dollar cost averaging can help limit some of the risk that comes with establishing a position in a volatile environment, it is more important to establish a portfolio that maintains a risk-appropriate asset allocation. Attempting to time the market can often be fruitless. For example, investors at the beginning of 2013 may have been waiting for a better entry point after watching the Standard & Poor's (S&P) 500 Index make a relatively quick 10% jump. If you had decided to keep waiting for a pullback, you would have missed out on the additional 50% gain that took place over the subsequent two years.
When you're investing, look to establish a long-term asset allocation that fits with your investment objectives. If you're a young investor, you can probably tolerate the risk that comes with a larger stock allocation. If you're retired or near retirement, focus on creating a portfolio of income-producing assets. While the chances of investing at just the right moment are almost zero, the proper asset allocation helps you maintain a risk-appropriate portfolio. At the same time, dollar cost averaging into those positions helps limit the risk that comes with getting in at the wrong time.
Another consideration when establishing the new portfolio is to focus on low-cost mutual funds and ETFs. Expense ratios and trading commissions can eat into your retirement savings, which can have a significant effect on your portfolio's performance as much as establishing the wrong entry point. Index funds often come with very low expense ratios, and limiting these costs helps keep more money in your pocket.
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